Fannie Mae (FNMA)

[obiterdictum]

STEALING FANNIE AND FREDDIE

Jonathan R. Macey
Yale Law School

Logan Beirne
Yale Law School

April 27, 2014

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2429974

Politicians are running rough-shod over the rule of law as they seek to rob private citizens of their assets to achieve their own amorphous political objectives. If we were speaking of some banana republic, this would be par for the course – but this is unfolding in the United States today.

“The  housing  market  accounts  for  nearly  20  percent  of  the  American  economy,  so  it  is  critical  that   we   have   a   strong   and   stable   housing   finance   system   that   is   built   to   last,”   declares   the   Senate   Banking   Committee   Leaders’   Bipartisan   Housing   Finance   Reform   Draft. The proposed legislation’s   first   step   towards   this   laudable   goal,   however,   is   to liquidate the government- sponsored enterprises Fannie Mae and Freddie Mac – in defiance of the rule of law. This paper analyzes the current House and Senate housing finance reform proposals and faults their modes of liquidation for departing from legal norms, thereby harming investors and creditors, taxpayers, and the broader economy.

Under proposals before Congress, virtually  everyone  loses.  First,  the  GSEs’  shareholders’  property   rights are violated. Second, taxpayers face the potential burden  of  the  GSEs’ trillions in liabilities without dispensing via the orderly and known processes of a traditional bankruptcy proceeding or keeping the debts segregated as the now-profitable GSEs seek to pay them down. Finally, the rule of law is subverted, thereby making lending and business in general a riskier proposition when the country and global economy are left to the political whims of the federal government.

I. Background

The Federal National Mortgage Association (commonly known as “Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”) are privately owned, for-profit mortgage finance companies whose shares trade on the New York Stock Exchange and remain two of the largest companies in the world, as measured by both asset value and revenue.3 They are known as “government  sponsored  entities”  (“GSEs”)  due to their federal charters, which charge each with providing stability and assistance to the secondary mortgage market and promoting access to mortgage credit.

Fannie Mae was created as federal government agency by Congress in 1938 amid the en masse mortgage defaults of the Great Depression. It was charged with creating a liquid market for residential mortgage-backed securities, with the aim of encouraging homeownership. Fannie Mae succeeded in its mission of creating a liquid market, but in the process accumulated substantial debt. In fact, it grew so large that by 1968 President Lyndon Johnson, faced with mounting public debt during the Vietnam War, moved Fannie Mae’s  debt  portfolio  off  of  the federal  government’s
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1 Sam Harris Professor of Corporate Law, Corporate Finance, and Securities Law, Yale Law School.
2 ISP Fellow, Yale Law School.
3 According to Forbes Global 500, available at http://money.cnn.com/magazines/fortune/global500/2013/full_list/?iid=G500_sp_full.
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balance sheet by converting it into a publicly traded company owned by investors.4 Mirroring Fannie Mae, Freddie Mac was then created in 1970 to prevent its predecessor from acting as a monopoly. It eventually went public in 1989. Both were consistently highly profitable over the decades and are now responsible for backing 90% of mortgages.

Historically, the federal government has explicitly refused  to  guarantee  the  companies’  liabilities. By statute, securities issued by Fannie Mae and Freddie Mac must contain an explicit disclaimer that they are “not guaranteed by the United States and do not constitute a debt or obligation of the United States.”5 As a longtime practical matter, however, the two companies   “are   so   deeply enmeshed in the regulatory regimes of other American financial institutions that the federal government has effectively signaled that it would support Fannie Mae and Freddie Mac if they were unable to make payments on their obligations.”6 This largely came to pass during the financial crisis of 2008.
   
II. Flawed Model: Chrysler and General Motors

During the severe economic downturn of 2008, many institutions suffered. The federal government’s  reaction  was  as  chaotic  as  it  was  mixed  – e.g. orchestrating the sale of Bear Stearns, allowing Lehman Brothers to fail, propping up Citigroup on favorable terms, bailing out AIG multiple times. For automotive giants, Chrysler and General Motors, the government resorted to a “political  bailout.”

Instead of the traditional bankruptcy reorganization process, the Obama Administration opted for a  “quick  and  surgical”  reorganization  that  would  “make  it  easier  for  Chrysler and General Motors to  clear  away  old  liabilities.”7 The bankruptcy process is meant to follow standard rules in which the proceeds of unencumbered assets are distributed to creditors according to a strict priority schedule, governed by the  nature  of  each  creditor’s  claim. Secured creditors, such as bondholders, come before the unsecured creditors, which in the case of Chrysler and General Motors included union health and retirement funds.8
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4 For  a  succinct  overview  of  the  GSEs’  history,  see  Kate  Pickert,  “A  Brief  History  of  Fannie  Mae   and  Freddie  Mac”,  Time  Magazine  (July 14, 2008), available at http://content.time.com/time/business/article/0,8599,1822766,00.html.
5 12  U.S.C.  §  1455(h)  (2006)  (regarding  Freddie  Mac’s  obligations  and  mortgage-backed securities); id. § 1719(b) (regarding certain Fannie Mae obligations); id. § 1719 (d), (e) (regarding  Fannie  Mae’s  mortgage-backed securities and subordinated or convertible obligations). David Reiss, The Federal Government's Implied Guarantee of Fannie Mae and Freddie Mac's Obligations: Uncle Sam Will Pick up the Tab, 42 GA. L. REV. 1019, 1023.
6 David Reiss, The Federal Government's Implied Guarantee of Fannie Mae and Freddie Mac's
Obligations: Uncle Sam Will Pick up the Tab, 42 GA. L. REV. 1019, 1025.
7 White House Office of the Press Secretary, Obama Administration Auto Restructuring Initiative (Apr 30, 2009) (www.whitehouse.gov/the_press_office/Obama-Administration-Auto- Restructuring-Initiative).
8 See, e.g. A. Joseph Warburton, Law And The Financial Crisis: Economic Regulation During
Turbulent Times, 60 Syracuse L. Rev. 531.
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However, the unsecured – but politically powerful – United Auto Workers union (“UAW”)  was   offered special treatment. The Obama Administration tied the large sums owed to the UAW to the companies’   assets   rather   than   discharging   these   liabilities   along   with   the   other   unsecured   creditors.9 In this way, the Government elevated the unsecured claims of organized labor above the secured claims of investors, overturning well-established creditor priorities in bankruptcy. This comes in spite of the Bankruptcy Clause’s uniformity requirement, which has long held to prohibit Congress from enacting bankruptcy laws that specifically apply to just one named debtor.10 Following a comparable, politically-motivated course of action with Fannie Mae and Freddie Mac would be detrimental to taxpayers, lenders, and the economy at large.

III. Federal Takeover

As the mortgage crisis gain momentum in 2007, Fannie Mae and Freddie Mac bowed to pressure from its federal overseers and began to purchase subprime and other risky securities in order to support the economy.11 Partially as result of this increase in subprime holdings, the companies were hit hard by the financial crisis of 2008.12

Although the GSEs never reached the point of insolvency, they experienced heavy losses and Congress enacted the Housing and Economic Recovery Act of 2008 (“HERA”), pursuant to which the federal government placed the companies into conservatorship. As conservator, the FHFA’s   duty is to conserve  the  companies’  assets  for  the  benefit  of  the  common and preferred shareholders with the expectation that the companies will return to sound condition in the future.13 Under section 1145 of HERA, the Federal Housing Finance Authority (“FHFA”,  the  independent federal agency that regulates the Fannie Mae, Freddie Mac, and the 12 Federal Home Loan Banks) may “take  such  action  as  may  be  — (i) necessary to put the regulated entity in a sound and solvent condition, and (ii) appropriate to carry on the business of the regulated entity and preserve and
conserve  the  assets  and  property  of  the  regulated  entity.”14

Acting via the Secretary of the United States  Treasury  (“Treasury”)  and  FHFA,  the government entered  into  senior  preferred  stock  arrangements  (the  “Stock  Agreements”)  with  Fannie Mae and Freddie Mac, whereby Treasury would advance $100 billion15 in exchange for $1 billion in shares of senior preferred stock with a cumulative 10% dividend and would be increased dollar-for-dollar by any amounts Treasury invested. Pursuant to the Stock Agreements, each company also issued
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9 Id.
10 Railway Labor  Executives’  Assn.  v.  Gibbons,  455 U.S. 457.
11 Particularly, the Office of Federal Housing Enterprise Oversight.
12 Fannie Mae and Freddie Mac had reported losses and faced sinking share prices but were nevertheless able to meet all obligations to all creditors up to and including when placed into conservatorship.
13 3 See, e.g., FDIC, RESOLUTIONS HANDBOOK 70–71 (2003), available at http://www.fdic.gov/bank/historical/reshandbook/index.html
(last visited Feb. 19, 2014)
14 12 U.S.C. § 4617(b).
15 In May 2009, this amount was extended to $200 billion.
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Treasury 20-year warrants to purchase 79.9% of the common stock for a mere $0.00001 per share.16 The FHFA Office of Inspector General acknowledged that these actions exacted a heavy toll on the existing shareholders' holdings.17 And despite the popular narrative that such investors were all leviathan hedge funds, many community banks invested heavily in preferred shares.18

Rather than working as conservator to benefit Fannie Mae and Freddie   Mac’s common and preferred shareholders, as is its obligation under traditional conservatorship law, the FHFA acted for the benefit of the U.S. government – and to the detriment of those private shareholders. Subsequent to the Stock Agreements, the government also forced the companies to delist their shares, suspend shareholder meetings, assume additional subprime assets, and accept tens of billions of dollars from the Treasury that were not necessarily needed to maintain solvency.19 In fact, as the company returned to profitability in 2012, the government used an administrative procedure to pass the Third Amendment to the Stock Purchase Agreement, thereby requiring “a   full income sweep of all future Fannie Mae and Freddie Mac earnings to benefit taxpayers for their investment.”20 Fannie Mae and Freddie Mac are generating cash – enough to more than repay the $187.5 billion in emergency funding received from the government during the downturn – but have been forbidden from  using  that  income  to  “put the regulated entity in a sound and solvent
condition.”21

“The purpose of a conservatorship is to preserve the assets for the benefit of the individuals whom it represents,”  as  Richard  Epstein  notes, “which in this instance covers both classes of shareholders. Accordingly, the conservator represents the shareholders in their relationship with the government. Under standard corporate law principles, that conservator is bound, by a strong fiduciary duty to protect the corporate assets for the benefit of both common and preferred shareholders.”22 In the case of Fannie Mae and Freddie Mac, however,  “the  designation  of  the  FHFA  as  the conservator created an impossible conflict of interest. The Boards of Directors of Fannie Mae and Freddie Mac were shut out of the deliberations that took place exclusively between branches of the federal government.”23 In pursuing their mandate to protect the third party taxpayers, the government is neglecting its duties to the shareholders – something that under traditional corporate law runs counter to a conservator’s  role.
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16 Complaint, Washington Federal v. U.S. 13-385 C, page 3.
https://docs.google.com/a/matterhorndata.com/file/d/0B6ofth- ELqJpcmRrZ3FpSWl6ZGs/edit?pli=1.
17 Id.
18 Nick Timiraos, Fannie-Freddie Bill Leaves Little for Shareholders, The Wall Street Journal (Jun 5, 2013), available at http://blogs.wsj.com/moneybeat/2013/06/05/fannie-freddie-bill- leaves-little-for-shareholders/.
19 Complaint, 9.
20 Treasury Department Announces Further Steps to Expedite Wind Down of Fannie Mae and Freddie Mac (Aug 17, 2012), available at http://www.treasury.gov/press-center/press- releases/Pages/tg1684.aspx (capitalization of the heading is altered).
21 12 U.S.C. § 4617(b).
22 Richard Epstein, Grand Theft Treasury, DEFINING IDEAS (Jul 16, 2013) available at http://www.hoover.org/publications/defining-ideas/article/151966.
23 Id.
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IV. Proposed Reform

The proposed housing finance reform legislation in the House and Senate seeks to continue down this path of eschewing legal norms. The H.R.2767 Protecting American Taxpayers and Homeowners   Act   of   2013   (“PATH   Act”),   S.1217   Housing   Finance   Reform   and   Tax   Payer   Protection  Act  of  2013  (“Corker-Warner  Bill”),  and  Amendment to S. 1217 Housing Finance Reform  and  Tax  Payer  Protection  Act  of  2014  (“Johnson-Crapo  Bill”)  all  seek  to  wind  down  the once again profitable companies without adequately protecting shareholder interests.24

Despite the debate over whether to preserve these now-profitable GSEs or perhaps sell them to private parties,25 the proposals repeal  the  GSEs’  charters  and  provide for the government to liquidate each.26

Each of the proposed bills compounds the government’s dereliction of its duties under the Administrative Procedure Act (APA).27 HERA was designed to return the GSEs to a sound and solvent state, but the government’s  self  dealing  (between  the  FHFA  and  Treasury)  is  violating  the   statute’s   safeguards and is instead absorbing and dissolving the interests of those private shareholders HERA was designed to conserve. For example, Sec. 604 of the Johnson-Crapo Bill states, “The  wind  down  of  each  enterprise  must  be  managed  by  FHFA  to  obtain  resolution  that   maximizes the return for taxpayers,”  thereby ignoring obligations to shareholders.28

The   reforms’   proposed   liquidations in effect finalize   the   government’s   taking   of   the   GSEs’   shareholders’   property.   In the words of Armstrong v. United States, the just compensation requirement of any taking was intended to prevent the government from forcing  “some  people   alone to bear public burdens which, in all fairness and justice, should be borne by the public as a whole.”29 But with the proposed liquidations, the government appears to be doing precisely that. As it continues to force the companies to invest in and hold toxic securities, the government is siphoning away the profits that the companies might use to regain their footing; and Congress plans to drive them into the ground without exploring other approaches that  may  help  shareholders’   recoup losses.

In fact, the Obama Administration in November 2013 rejected a corporate bid for the GSEs’ insurance businesses. Rather than allow private businesses to invest $52 billion in an effort to restructure Fannie Mae and Freddie Mac into profitable private companies that follow industry
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24 Rep.  Maxine  Water’s  “Housing  Opportunities  Move  the  Economy  Forward  Act  of  2014”  does   not seek to codify Treasury's takings.
25 See e.g. Andrea J. Boyack, Laudable Goals and Unintended Consequences: The Role and Control of Fannie Mae and Freddie Mac, 60 Am. U.L. Rev. 1489 (June 2011).
26 Section 101 of H.R.2767; Section 501 of S.1217; Section 602 of Amendment to S. 1217.
27 See, e.g., claims filed in Fairholme Funds v. FHFA and Perry Capital v. Lew. Epstein, supra note 12.
28 Section 604 of Amendment to S. 1217
29 364 U.S. 40 (1960), as quoted in Epstein, supra 18.
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best practices,30 the Administration has promoted the proposed legislation – and, along with it, the politically-motivated liquidation it entails.

Further, the Senate proposals potentially burden  taxpayers  with  Fannie  Mae  and  Freddie  Mac’s   enormous   liabilities.   According   to   economist   James   Hamilton,   the   mortgage   giants’   liabilities   amount to $5.2 trillion,31 representing a 29.6% increase to the record $17.54 trillion national debt should the full sum be pulled onto the federal balance sheet.32

The proposals effectively reverse  LBJ’s  1968  removal  of  Fannie  Mae’s debt portfolio from the U.S.’s  books.  As  the  Associated  Press  reported  in  2008,  “with  the government takeover of Fannie Mae and Freddie Mac, U.S. taxpayers now essentially own the bulk of the nation's mortgage market.”33 In other words, when Fannie Mae and Freddie Mac went into conservatorship in September 2008, the two GSEs became, in the words of the Congressional Budget Office, “governmental,”  and  this  “effectively  made  the  government’s  backing  of  their  debt  securities  and   [mortgage-backed   security]   guarantees   explicit.” 34 Rather than maintaining these profitable companies, selling them to private parties,35 or discharging the debt via a traditional bankruptcy process,36 the Senate proposals seek to codify this massive burden by pledging the full faith and
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30 Tom Risen, White House Opposes Privatizing Fannie Mae and Freddie Mac, New York Times (Nov 23, 2013), available at http://www.usnews.com/news/articles/2013/11/21/white-house- opposes-privatizing-fannie-mae-and-freddie-mac.
31 Federal Housing Finance Agency, Enterprise Share Of Residential Mortgage Debt Outstanding: 1990–2009  [hereinafter  “FHFA  Chart”],  available  at   http://www.fhfa.gov/webfiles/15556/Enterprise%20share%20of%20Resident%20Mortgage%20 Debt%20Outstanding%201990_%202009.xls.
32 The GSE liabilities will only need to be covered by taxpayers if there is another downturn in the housing market.
33 Tom Raum, US rescue of Fannie, Freddie poses taxpayer risks, USA Today (Sep 8, 2008), available at http://usatoday30.usatoday.com/news/washington/2008-09-08-127573146_x.htm. 34 p. 3 and p. vii of the 2010 CBO report.
35 As discussed supra, the Obama Administration rejected a corporate bid for the insurance
business of Fannie and Freddie.
36 Others have written of the inadequacies of the Bankruptcy Code as a mechanism for resolving
systemically important institutions and discussed possible reforms to the Code. See, e.g. Edward
Morrison,  “Is  the  Bankruptcy  Code  an  Adequate  Mechanism  for  Resolving the Distress of
Systemically  Important  Institutions?”  82  Temple  Law  Review  449  (2009);;  David  Reiss,  “An
Overview  of  the  Fannie  and  Freddie  Conservatorship  Litigation”,  Draft  Journal  of  Law  &
Business (forthcoming 2014). It is not the purpose of this paper to make broad claims about the
best route for all institutions, but instead to evaluate the proposed liquidation specific to Fannie
Mae and Freddie Mac. While the Code may present challenges with regard to speed and
flexibility during crises, not only were these companies never insolvent, they have stabilized and
are even profitable once again. Further, their proposed liquidation comes after specific
government obligations to existing shareholders.
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credit of the United States for both GSE legacy debt and legacy mortgage-backed securities,37 thereby   further   imperiling   the   nation’s   credit   rating,   curtailing   economic   growth,   spurring   inflation, threatening social programs, and diminishing the  nation’s  social, economic and political power.

In a traditional bankruptcy proceeding under Chapter 11 of the Bankruptcy Code,38 the plans for liquidation of Fannie Mae and Freddie Mac must comply with the absolute priority rule. 39 After payment of the inevitable administrative expenses – attorneys and accountants for the Debtor, the committee of creditors, and the likely committee of equity holders – secured creditors must be made whole before any other claimant may receive any recovery. Next, priority claims, such as tax claims, must be paid before unsecured claims (effectively all debts for which no security interest has been pledged) are then paid. Finally, the equity holders would recover, with preferred shareholders receiving higher priority than common shareholders. This is the orderly process by which debts are equitable discharged that has long marked the liquidation of private companies and has been internalized by the market.

Under the proposed liquidations, however, virtually everyone loses. Not only are the GSEs’   shareholders’  property rights are violated, the U.S. taxpayers face the burden of the  GSE’s  trillions   in liabilities without dispensing via the orderly and known processes of a traditional bankruptcy proceeding or keeping the debts segregated as the now-profitable GSEs seek to pay them down. Finally, the rule of law is subverted, thereby making lending and business in general a riskier proposition when the country and global economy are left to the political whims of the federal government.

The United States was founded  on  a  firm  commitment  to  Americans’  property rights. In fact, of the  Declaration  of  Independence’s  charges  against  King  George  III,  a majority of the ten are offences against private property. The political winds of the moment make it popular to extract short term taxpayer advantage on the backs of what is popularly perceived as the moneyed hedge fund shareholders of the GSEs;40 however, we cannot permit such political pressure to allow crony capitalism to take hold as the government picks  the  economy’s  winners  and  losers  by  changing  the   rules of the game. In the longer run, the governments’  handling  of  Fannie  Mae  and  Freddie  Mac   could subvert certainty and order – a key competitive advantage for the U.S. economy in attracting investment. With Chrysler, General Motors, and now Fannie Mae and Freddie Mac, a growing number of precedents erode the rule of law that has enabled the United States to thrive.

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37 Section 501 of the Corker-Warner Bill, Section 604 of the Johnson-Crapo Bill. But see, Rep. Maxine  Water’s  “Housing  Opportunities  Move  the  Economy  Forward  Act  of  2014”,  which  does   not seek to codify Treasury's takings.
38 Chapter 7 would likely not be a good vehicle for something so large, but, in theory, a Trustee would be appointed, and she or he would distribute assets according to priority.
39 11 U.S.C. §1129(b)(2)(B)(ii).
40 While  we  cannot  know  the  identities  all  of  the  GSEs’  investors  they  are  almost  certainly  not  a   monolithic  group  of  hedge  funds  but  also  likely  include  individuals’  401ks  and  pensions  as  well   as smaller investors including community banks.